Didier Fréchette, Ryan Rabinovitch, "Current Issues Involving Foreign Exchange", 2015 CTF Annual Conference paper

Dealing with FX gain on U.S. dollar loan by Can LP to Cansub to fund on-loan to US Opco: asymmetrical application where s. 51 applies (pp. 26: 19-22)

A private equity fund, Can LP, makes a US$100 million loan to its wholly owned Canadian subsidiary, Cansub. Cansub, in turn, uses the funds to make a loan denominated in US dollars to its US operating subsidiary, US Opco. At the time the loan is made, the Canadian dollar is at par with the US dollar. Subsequently, the value of the US dollar increases to Cdn$l.25….

[T]he following steps could be carried out...:

1) Cansub establishes Forco in a jurisdiction that has an income tax treaty with the United States and Canada.

2) Cansub transfers the US Opco loan to Forceco as consideration for shares of Foreco.

3) The Cansub loan is amended to add a conversion right…

4) Can LP exercises the conversion right and converts the Cansub loan into preferred shares of Cansub having a redemption and liquidation value equal to the outstanding amount under the loan, converted into Canadian dollars on the date of the conversion. ... Cansub realizes a foreign exchange loss of Cdn$25 million. This loss is used to offset the Cdn$25 million gain realized upon the transfer of the US Opco loan to Forco.

[P]ursuant to paragraph 51(1)(c), the conversion [in 4] should be deemed not to be a disposition for Can LP... .

[T]he application of section 51 to the transaction should not affect the issue of whether a gain or loss is realized by the debtor (Cansub)….[T]he amount paid pursuant to the agreement of the parties and the amount added to stated capital would be equal to the amount outstanding under the debt, converted into Canadian dollars on the date of the conversion (namely, Cdn$125 million). ...

The above example illustrates the asymmetry that is inherent in section 51. It is unclear whether the CRA would seek to invoke GAAR in this scenario. As mentioned above, the CRA has noted in the past, with respect to a convertible debenture issued by a Canadian corporation to its US parent, that this type of arrangement seemed "artificial" and could be challenged if it gave rise to "anomalous tax results." [f.n. 67: …"Canada Revenue Agency Round Table," in the 2009 Conference Report, ... question 33]

Realization of gain by debtor but not creditor on internal assumption (pp. 26:22-23)

In both [rulings: 2007-0239291R3, 2007-0252491R3], the taxpayer had capital losses that would otherwise have expired as a result of the acquisition of control, and wanted to trigger the gain on its external debt denominated in US dollars prior to the acquisition of control. [f.n. 71: The transactions implemented in the above rulings preceded the introduction of subsection 111(2)... .]

The taxpayer in the rulings ("Parentco") incorporated a new wholly owned Canadian subsidiary ("Newco"). Parentco then transferred assets to Newco in consideration for Newco shares and the assumption by Newco of a portion of a Parentco external debt denominated in US dollars. Upon the assumption, Newco was added as a "co-obligor" (without Parentco being correspondingly removed as co-obligor or guarantor), and Newco and Parentco became jointly and severally liable for the entirety of the debt. The taxpayers represented that, under the applicable commercial law, the assumption did not result in a novation… .

The CRA confirmed in the rulings that, as a result of the assumption, Parentco would "make a gain" in respect of the assumed debt under subsection 39(2). Because Parentco remained liable for the entirety of the assumed debt as co-obligor and because there was neither a novation of the original debt nor a rescission, one might wonder why Parentco would be considered to have realized a gain. ...

[I]t seems reasonable to suggest that, because the assumed debt formed part of the consideration for the transfer of assets by Parentco to Newco, as between Parentco and Newco, Newco became the "primary debtor"… .

While the creditors preserved all of their rights against the original debtor, it appears that, as between the two co-obligors, Parentco's position became similar to that of a guarantor. In that sense, Parentco was, in effect, "relieved" of its obligation… .

The CRA confirmed that the proposed assumption of the debt by Newco would not, in and of itself, result in a disposition of the debt for the holders... .

The rulings thus confirmed the asymmetric treatment of the transaction: the assumption of a portion of the original debt resulted in the triggering of a foreign exchange gain for the debtor, but was a non-event as far as the debtholders were concerned.

When an FX-denominated debt is repaid by issuing a replacement debt denominated in the same currency, there is an argument that no s. 39(2) gain or loss is realized (pp. 26:28-29)

Somewhat surprisingly, ...Imperial Oil...cast doubt on the soundness of the CRA's view regarding the foreign exchange implications of a debt repayment. Relying on...Marine Midland...the court indicated that the mere repayment of a foreign-currency-denominated principal in the same currency could not yield a profit or a loss, and that any appreciation or depreciation in principal amount does not result from the simple fact that the amount has been borrowed and repaid.

[I]n Income Tax Technical News no. 38, the CRA stated:

[W]here U.S. dollar denominated loans are repaid with newly borrowed U.S. dollars…a taxpayer will be considered to have "made a gain" or "sustained a loss"….

The analysis is less straightforward when a foreign-currency-denominated debt is repaid with another debt, particularly when that debt is denominated in the same currency….To the extent that the taxpayer remains equally exposed to changes in the value of the relevant currency before and after a debt-for-debt exchange, it could be argued that no gain or loss has been "realized"… .

Repayment of FX debt with Cdn-dollar note (pp. 26:31-32)

[T]he application of paragraph 80(2)(k) is less straightforward, however, when the debt is repaid in Canadian dollars. ...

The issue arose in [9601795] involving the following facts. A US$1,000 note was issued by a Canadian company for US$1,000 at a time when the US dollar was worth Cdn$1.40. The note was then repaid using a Cdn$1,000 note when the US dollar and the Canadian dollar were trading at par. Because the debt was repaid with a promissory note, it was necessary to apply paragraph 80(2)(h), which states that where an old debt is repaid with a new debt, an amount equal to the principal amount of the new debt is deemed to have been paid in satisfaction of the old debt.

The CRA applied somewhat convoluted reasoning to avoid the application of the debt-forgiveness rules. It concluded that the principal amount of the Cdn$l,000 note must first be converted into US dollars at the exchange rate in effect at the time of repayment (into US$1,000), and then be converted back into Canadian dollars at the exchange rate in effect at the time the debt was originally issued (into Cdn$1,400). The result of these calculations was that the amount paid in satisfaction of the debt was the same as the principal amount and the amount paid in satisfaction of the note. ...

Notwithstanding the policy intent, the CRA's reasoning has been criticized on the basis that it produces the wrong result in the "reverse scenario," described as follows. [fn 98: See Firoz Ahmed and Jack A. Silverson, "The New Debt-Forgiveness Rules: Planning Opportunities and Traps for the Unwary,"…1996 Conference Report…21:1-38. ...] A US$1,000 note is issued by a Canadian company when the US dollar and the Canadian dollar are trading at par, and is then repaid using a Cdn$1,000 note when the US dollar is worth Cdn$1.40. Under paragraph 80(2)(k), the principal amount of the old note is deemed to be Cdn$1,000, and the principal amount of the new note—using the reasoning of the CRA—must be converted into US dollars using the current exchange rate (resulting in an amount of US$714), and then back into Canadian dollars using the exchange rate in effect at the time the note was originally issued (resulting in an amount of Cdn$714). Accordingly, a debt forgiveness of Cdn$286 results. The authors state that this contradicts the purpose of paragraph 80(2)(k), which is to avoid a debt forgiveness arising as a result of a currency fluctuation. …

In our view, the result reached in what is characterized as the reverse scenario is not inappropriate. The issuer has a Cdn$286 debt forgiveness, but presumably it also has a Cdn$286 foreign exchange loss (thus resulting in a new tax attribute). The issuer has repaid US$714 of its loan with Cdn$1,000 and the issuer received Cdn$714 for this portion of the loan. …

Repayment of FX debt with FX-denominated property (pp. 26: 32-33)

Similar questions arise when a foreign-currency denominated debt is repaid with foreign-currency denominated property, such as an amount owing to the debtor (by setoff), a promissory note/debt owing by a third party, or preferred shares denominated in foreign currency. ...

The taxpayer in Richer owed US$1.3 million to the manager of four limited partnerships, which had made loans to the taxpayer in an amount sufficient to permit him to make certain capital contributions to the partnerships. The manager of the limited partnerships owed the taxpayer US$0.1 million in damages as a result of having improperly charged management fees to the limited partnerships, and its obligations to the taxpayer were set off against the US$1.3 million owing by the taxpayer. Jorré J of the Tax Court of Canada held that the "amount paid" in respect of the US$1.3 million must be computed using the exchange rate in effect at the time the US$1.3 million debt first arose under paragraph 80(2)(k).

Whether deemed dividend on redemption of USD preferred shares (pp. 26:35-39)

A Canadian-resident corporation issues preferred shares for US$100 per share at a time when the US dollar and the Canadian dollar are trading at par. The shares are redeemed at a time when the US dollar is worth Cdn$1.33. ...

[T]he issuer...does not realize any foreign exchange loss on the redemption of the preferred shares. ...

It is less clear, however, what the impact of the redemption is on the holder of the foreign-currency-denominated preferred shares and, more particularly, whether the corporation is deemed to have paid, and the shareholder's deemed to have received, a dividend. ...

The "amount paid" upon the redemption appears to be Cdn$133, pursuant to paragraph 261(2)(b). ...

Assuming that it is permissible for the stated capital of a Canadian-resident corporation to be maintained in US dollars, the stated capital of the preferred shares in this case would be US$100. This amount would then have to be converted into Canadian dollars on the date on which it "arose" pursuant to paragraph 261(2)(b). On the basis of the historical position of the CRA, this would be the day on which the shares were issued, although it could be argued—given that the definition of PUC specifies that it is an amount that is to be determined "at any particular time"—that the PUC in respect of the shares should be considered to arise from time to time (that is, at any time that it is calculated). …

[A]ccording to [9634245], it is not possible to specify an amount in foreign currency. …

[T]his interpretation is arguably inconsistent with the tax policy underlying subsections 191(4) and (5)… [and] with [CRA's] position regarding the application of section 51.1... .

Whether substitutions for s. 93(2.1) purposes are not limited to share-for-share transactions (p. 26:47)

The CRA has taken an expansive view of the concept of substituted property. In particular, it has taken the view that substitutions are not limited to share-for-share transactions, [fn 135: See for example, CRA document no. 2012-046490117, May 10, 2013.] such that subsection 93(2.1) can apply where shares of a foreign affiliate have been disposed of on a fully taxable basis for cash or a promissory note and the proceeds are ultimately reinvested in a new foreign affiliate. Whether this position is correct at law is debatable.

Having regard to the text, context, and purpose of subsection 93(2.1), there seems to be a reasonable interpretation that a taxable disposition of the shares for cash (or a promissory note) should break the chain of substitutions, such that dividends paid on the original shares should no longer be relevant. The French version of subsection 93(2.1) specifically refers to share substitutions ("actions de remplacement"). The English version of subsection 93(2.1) refers to "the affiliate share or a share for which the affiliate share was substituted." The word "share" in the provision must be given the meaning ascribed by subsection 248(1). Other forms of property (such as cash or a promissory note) would not be viewed as a "share." Other provisions of the Act clearly refer to "substituted property," [fn 136: See, for example, the attribution rule in subsection 74.1(1), which refers "to any income or loss, as the case may be, of that person for a taxation year from the property or from property substituted therefor." See also subsection 149.1(1), which refers to "substituted shares.] supporting the view that the different language in subsection 93(2.1) should have a different meaning. …

Streaming of dividends on preferred shares (MRPS) for non-93(2.1) avoidance reasons (p. 26:49-50)

Consider the example of a financing structure commonly implemented by Canadian-based multinationals, which was the subject of an advance tax ruling issued by the CRA in 2011. [fn 145: …2010-0375111R3, 2011….] The structure described in the ruling involved the formation of a financing foreign affiliate in a third country to finance, by way of loans denominated in US dollars, the operations of another foreign affiliate in the United States. The financing affiliate was capitalized with "zero percent" mandatory redeemable preferred shares (MRPS) with no dividend entitlement, and common shares. Typically, to comply with the tax rules in the foreign country, approximately 99 percent of the capital would be contributed in exchange for MRPS, and the remaining 1 percent would be contributed in exchange for common shares. As the financing foreign affiliate earned interest income, dividends would be paid on the common shares, and not on the preferred shares. In the event that the US dollar declined in value, a loss would ultimately be realized on the windup of the financing affiliate. The loss would be driven exclusively by the decrease in value of the US dollar. Because the financing affiliate was capitalized almost exclusively with preferred shares but the dividends would be paid only on the common shares, the loss realized on the disposition of the preferred shares would not be reduced pursuant to subsection 93(2.1). Would the CRA seek to invoke GAAR to deny the loss? In this fact pattern, the use of the preferred shares was dictated by foreign tax reasons.

Streaming of dividends on preferred shares for loss-shifting rather than 112(3) avoidance reasons (p. 26:50)

A similar issue [to the avoidance of s. 93(2.1)]...can arise in the domestic context. Assume that Canco 1 acquires all of the common shares of a second Canadian corporation, Canco 2, for $100 million. Over the years, because Canco 2 has loss carryforwards and Canco 1 is in a taxable position, a standard internal loss consolidation arrangement is put in place, in which Canco 2 makes an interest-bearing loan to its parent, Canco 1, and Canco 1 uses the funds to subscribe for preferred shares of Canco 2. The instruments (the loan and the preferred shares) have similar terms and conditions (yield, maturity, etc.). The structure stays in place for several years, resulting in significant dividends being paid by Canco 2 on its preferred shares. A few years after the loss consolidation arrangement is dismantled, Canco 1 sells the common shares of Canco 2 for $80 million, thus realizing a loss of $20 million. Subsection 112(3) does not apply to reduce the loss, because all the dividends were paid on the preferred shares, while the loss is realized on the common shares. Would the CRA seek to apply GAAR in this fact pattern?